I know you guys may have done this a lot, but I need some help understanding why the credit expansion creates malinvestment, or misallocates capital. I don’t understand the explanations I always read, but I’m new to eocnomics. Can someone also show examples on how the U.S. misallocated its capital?
bump
-
See all those new houses?
-
See how empty they are?
-
See how high the prices used to be?
-
There’s your example of misallocation.
And you should wait more than 15 minutes before bumping a thread.
Now as to why the credit expansion causes misallocations: the lower the interest rate (expansion of credit is lowering the rate) sends signals that some investment might be profitable now vs. at a higher interest rate for the loan. So people borrow at the low rate, build, and then when the market gets oversaturated, take a hit and lose a lot.
Credit expansion generally implies interest rates that have been manipulated in ways that reduce the rate. This implies that there are many people that have long time horizons before consuming. With this in mind, companies take out loans to construct elaborate and long duration projects to increase production for the future. However, eventually the manipulation that led to the low interest rates ends or many of the project are completed only to find that the expected consumer base isn’t there. The businesses are then forced under, the result of which is a recession.
Unfortunately, i can’t think of any links off the top of my head but i’ll try to keep this thead in mind when i’m surfing.
There are some good lectures which flesh it out pretty well here on Mises. Rothbard’s is pretty good: http://media.mises.org/mp3/rothbard/R3-16m.mp3
Is there something in particular you don’t understand about the ABCT?
Interest rates, in their natural occurrence, merely reflect the time preference of a society. If people are future-oriented, they save a lot, more saved capital is available and interest rates decline. If people are present-oriented, they consume a lot, less saved capital is available and interest rates rise.
A central bank is the socialist substitute for market interest rates. Central planners arbitrarily set the interest rates and hope this will somehow do the economy a better service than if markets determined it. Of course, the actual theory behind central banking is much more sophisticated, but that’s what it boils down to.
Now consider the example of contemporary America. People consume more than they save. Interest rates on a free market would be skyrocketing; saving would become profitable for those on the margin of present-orientedness and capital would be built up. Instead, the central bank pursued a policy of low interest rates in the Greenspan era. This had two effects:
- Investors thought: great, there’s a lot of cheap long-term capital available. I’ll start producing long-term goods now.
- Consumers thought: great, there’s a lot of cheap spending credit available. I’ll buy now instead of later.
Obviously, there’s a discrepancy between what consumers demand and what markets produce due to an artificial central bank interest rate that leaves general time preference completely out of the picture. Investment takes place in long-term endeavors, consumption in short-term ones; the enterprises that seemed profitable due to a low interest rate turn out to be wasteful and failing, and that’s what we call a malinvestment.
Not sure whether this answer is accurate or complete, but it covers at least one aspect I think.
Well the theory rests basically on the non-neutrality of money. This means that the first people who use new money benefit from it in the short term the most. It takes time for money that is created to circulate throughout the economy, raising prices. That said, if a disproportionate amount of new money is dumped in certain markets, those markets will temporarily become much more profitable. This will create malinvestment. This is basically what central and fractional reserve banking do. The newly created money first enters the credit, capital, and stock markets. This causes a disproportionate amount of investment in these areas, causing bubbles. But as the money begins to circulate throughout the economy, people reestablish their savings/spending ratio by purchasing more consumer goods than they did before. This diminishes the profitability of the long term capital investments, which in turn kills the credit/asset bubbles created by credit expansion.
It’s key to think of this as a problem of forced savings. When all of this new, unsaved credit is created, the projects it will fund are not projects that are actually desired by consumers. When the new money is finally obtained by consumers, they correct the process by consuming more. When capital goods industries begin to go out of business due to this readjustment of investment, they are forced to employ less workers and pay lower wages. These unemployed as well as those still employed at lower wages consume less, leading to a loss of profitability in the consumption/retail sector of the economy as well. This is what we call a recession, bust, or depression.
This is the shortest and simplest explanation I could write.
Great responses, thank you.
Since there have been responses that explain the process nicely, I won’t bother trying to provide one and I’ll give you some helpful links.
Here’s the mises media archive for ABCT, I strongly recommend listening to Salerno’s lecture, Thornton speeches are quite helpful also: http://mises.org/media.aspx?action=subject&ID=12
Here’s Huerta de Soto’s Money, Bank Credit and Economic Cycles, which is extremely helpful, although quite long and perhaps not easy for beginners: http://mises.org/books/desoto.pdf
Here’s Rothbard’s America’s Great Depression, the first part of which explains the theory behind the buisness cycle: http://mises.org/rothbard/agd.pdf
Also, if you haven’t, try reading Callahan’s Economics for Real People, which is a great book for beginners and has a simple explanation of it.
Think of a manipulated interest rate as a price under a price control, then apply price control theory. If the latter is intuitive and easy to understand, the former is greatly clarified, as it is merely a subspecies of it.